Saturday, May 22, 2010

The OECD Factblog highlighted a comparison of tax burden across the OECD countries. The main findings of the comparison is that overall tax burden, measured as a percentage of labor costs, is the highest in Western European countries. Belgium, Hungary, Germany and France are the countries with the highest overall tax burden while Ireland, Iceland, Australia and Korea have sustained low tax wedge. The data acquired by the OECD pose an intriguing question: is slow economic growth in European countries attributed to high tax burden of labor supply and, if so, has the gap between the U.S. and Europe grown further?

Let's decompose the data and underline the main findings. Tax wedge, measured as a percentage of taxes and transfers paid in the share of total labor costs, is a suficient measure of the overall level of taxation. In the analysis of the effect of taxation on labor supply, the economic theory distinguishes between substitution and income effect. The former means that tax rate on labor supply would reduce the number of working hours and shift the individuals to allocate more time into leisure. The income effect, on the other hand, states that the effect of tax on labor supply would be neutral and would, hence, not have an effect on the relative allocation of resources between working hours and leisure. In general, there are two largely opposing views in economic policy regarding the relationship between taxation and labor supply. Conservative and liberal economists tend to emphasize the role of incentives. Higher tax rate would raise the labor cost and the corresponding decline in wages would be offset by the re-allocation of resources into leisure sector of the economy. Left-wing economists mostly disagree with the abovementioned proposition. Instead, they emphasize the role of elasticity of labor supply. According to New Keynesian view, short-run tax elasticity of labor supply is low in absolute terms, meaning that the amount of working hours does not respond significantly to relative changes in tax rates. The Keynesian economists thus emphasize the significance of income effect while the conservative and liberal economists tend to emphasize the substitution effect. The distinctions and policy effects of these two theoretical propositions remains a controversial issue of economic policy debate.

The country distribution data is extensively underlined in the data (link). For example, one-earner married couple at 100 percent of earnings distribution is taxed at 20 percent of the overall labor cost in the United States, 22 percent in Australia, 18 percent in Switzerland and 13 percent in New Zealand. On the other tax wedge statistics for Western Europe is a completely different picture. In Sweden, one-earner married couple at 100 percent of earnings distribution will earn only 57 percent of net earnings, indicating a 43 percent effective tax rate on labor supply. In Belgium, the effective tax rate on labor supply is 42.6 percent. Is the difference in effective tax rates statistically significant feature of productivity variation across OECD countries. The OECD recently composed a breakdown in key productivity statistics in developed countries (link). To estimate the relationship between productivity and tax burden, I collected data on multifactor productivity dynamics from Groningen Growth and Development Center (link) and data on tax wedge across OECD countries (link). I estimated the noted relationship for 16 developed OECD countries. Multifactor productivity is a dependent variable while tax wedge is an explanatory variable.The estimates are displayed on the graph below.

Multifactor productivity in OECD relative to the U.S. and total tax burden (% of labor cost)

Source: GGDC, OECD Factblog

The horizontal line on the graphs marks the U.S. level of multifactor productivity. As the graph shows, the underlying relationship between multifactor productivity (MFP)and tax wedge is fitted with quadratic equation. Total tax wedge explains about 34.5 percent of the variation in multifactor productivity index across OECD countries. The trend exerts a decreasing MFP as the tax wedge rises and, after reaching a local minimum, a slight increase alongside the proporional rise in tax wedge. The relevant question is at which rate of tax wedge the MFP reaches the minimum. Setting the first-order derivate to zero (dy/dx=0) yields 0.0016x-0.0488=0. Rearranging the equation yields x=30.5. The first-order derivative implies that MFP reaches the minimum at 30.5 percent tax wedge. The estimate sample-based tax elasticity of productivity ((dy/dx)(x/y)) is 1.78. The elasticity indicates that 1 percentage point increase in tax wedge would reduce the multifactor productivity in a sample country by 1.78 percent, ceteris paribus. In other words, the estimated slope coefficient suggests that a 1 percentage point increase in tax wedge would widen the MFP gap between the average country and the US by additional 0.05 index points.

In economic terms, MFP would decrease as long as the countries in the sample would exert less than 30.5 percent tax wedge. In the horizon after the local minimum (30.5 percent), MFP would initially increase but at a smaller rate than before the function would reaches the minimum point. At 20 percent tax wedge (close to Japanese level), the expected decrease in MFP would be 0.0168 index point. At 40 percent tax wedge, the expected increase in MFP would be 0.0152 index point. Economically, the relationship between MFP and tax wedge should not be interpreted as a mixed effect of tax wedge on MFP. In countries, where tax wedge exceeds 30.5 percent (Austria, Denmark, Sweden, Belgium etc.) , the multifactor productivity is close to the U.S. level. The only country with higher MFP level than the United States is Luxembourg. In these countries, the average number of annual hours worked per worker is lower than in the U.S. Hence, hourly productivity output is higher. The following graph illustrates the relationship between annual hours worked (per worker) and MFP level.

Average annual hours worked per worker and multifactor productivity relative to the US

Source: OECD Statistics (2010)

As the graph illustrates, there is a negative relationship between average annual hours worked and MFP. The estimated regression coefficient suggests that an increase in annual hours worked by 100 hours would reduce MFP level (compared to the U.S) by 0.06 index points. As expected, the implied elasticity of productivity is negative. Taking the average values ov both variables, an increase in average annual hours worked (per worker) by 1 percent would reduce the MFP relative to the U.S level by 1.16 percent, ceteris paribus.

The conclusion is that there is a significant and negative impact of tax wedge on multifactor productivity. Taking the differences in annual hours worked into account, tax wedge alone explains almost 35 percent of the differential in multifactor productivity across the OECD. The findings suggest that there is a relatively strong substitution effect in labor supply. The finding is underlined by the fact that higher tax wedge would correspondingly reduce annual hours worked. However, the interpretation should be taken with a grain of warning. As previous empirical studies have shown, there is a widespread disparity in the distribution of working hours in formal and household sector of the economy. A sizeable proportion of working hours in household sector of the economy is not officially measured. Consequently, a blick of distortion of the real relationship between labor supply and tax wedge, in its broadest sense, is a major impediment to the measurement of labor supply dynamics. These estimates will, in a large part, determine the future research of the effect of taxation on labor productivity.

Tuesday, May 11, 2010

The $140 billion rescue package to Greece is a milestone in the European Monetary Union. A lively debate on recent macroeconomic imbalances in the weakest economies of the Euroarea - Greece, Italy, Spain and Portugal - in the Eurozone has reopened the old debate on whether the Eurozone is an optimum currency areas (here, here, here and here). The idea of optimum currency areas was first proposed by Nobel-winning economist Robert Mundell. In general, if several countries form a currency union, they should have at least four common macroeconomic features as essential framework of the currency union. In this article, I'll review the labor market criteria and fiscal adjustment criteria in the light of a recent imbalances in the Euroarea, and leave production diversification and export criteria for future discussion.

First, there should be a high degree of labor mobility between countries in the currency union. The basic idea behind the labor mobility criteria is that the lack of labor mobility triggers divergence of productivity growth rates and asymmetric adjustment of wages. If inter-country productivity divergence persists, there is an upward pressure on wages adjustment given the lack of exchange rate adjustment since the countries share a common monetary policy. The formation of the currency union in the United States was relatively straightforward given the fact that labor mobility between the states is very high. In Europe, the level of labor mobility is relatively low. The lack of labor mobility has a lot to do with labor market institutions in European countries. Workers from the European periphery can hardly move to Germany, Netherlands or Denmark as they do not speak the same language. The lack of inter-country mobility resulted in significant wage premiums and rise in rents since European labor markets share a pretty high degree of monopoly power since European workers can't switch easily between labor market structure. The resulting outcome of the lack of labor market competition was a significant "union capture" of the labor market, leading to rigid wage determination and high market switching costs.

Paul Krugman recently argued (link) that the major problem behind the European Monetary Union is the lack of common fiscal policy. To a very large extent, the absence of common fiscal policy seriously affects the future prospects of the European Monetary Union. Common fiscal policy could easily absorb asymmetric shocks withing the Euroarea. However, instituting the policy could not alter the trade-off between fiscal autonomy and asymmetric shock intensity. In other words, the main problem of the Euroarea right now is the free-riding of Eurozone's most problematic countries on a common monetary policy using disrectionary fiscal policy. Before the economic crisis, Spain had a budget deficit while, at the moment, the 2010 budget deficit forecast is more than 8 percent of the GDP. The estimate Greece's balooning public debt in 2009 ranges from 110 to 115 percent, depending on the consensus forecast. If the EMU countries unified a fiscal policy, the countries would not have an incentive to free-ride on discretionary fiscal policy and further increase the stock of public debt. The major impediment on the recovery and long-term economic outlook of Eurozone countries is largely dependent on how these countries will reform the pension systems in the light of a growing old-age dependence and a near fiscal insolvency of the pay-as-you-go (PAYG) pension schemes. It will be impossible to reverse the aging population and its persistent pressure on an increasing public debt. The integration of fiscal policy would require a sizeable harmonization of taxes given high costs of coordination and sufficient incentives for moral hazard. Without the reversion of long-term public debt pressure from aging, discretionary spending and entitlements, countries such as Greece, Spain and Portugal would leave the Eurozone.

Tuesday, May 04, 2010

Urska Zagar posted two very interesting empirical articles (here and here) about the connections between corruption, economic freedom and economic welfare. The first two indicators are qualitative while the third one is rather easily measurable. In a sample of 50 advanced, developing and least developed countries, she found a positive and robust correlation between corruption perception and GDP per capita, meaning that higher GDP per capita, on average, reduces the scope of corruption. The relationship between corruption and economic development is in fact even more intriguing than empirical figures suggest.

The impact of corruption on economic growth is an important theoretical and empirical theme in the economic literature. In this theoretical and empirical post, I will briefly review the main literature on corruption and development and discuss the empirical studies.

I would firstly refer to the article by Rodrik, Subramanian and Trebbi (2002) where the authors discuss the primacy of institutions for economic development over the exogenous factors such as geography (link). There has been an extensive amount of literature on the role of geography in economic development. The empirical strategy is quite simple. Usually, the basic equation includes the list of explanatory variables such as distance from equator, the percentage of land used for agricultural production and so forth. For example, the basic equation might take the following form:

log(GDP)=b1+b2(Dist)+b3(Land)+b4(Dummy_SubAfrica)+e

where GDP stands for GDP per capita, Dist for distance from equator, Land for the percentage of fertilized land and Dummy_SubAfrica is a dummy variable, taking the value of 1 if a country is located in the Subsaharan Africa and 0 if otherwise. In addition, e represents stohastic error unexplained by the selected predictors.

However, the basic problem with geographic approach to explaining economic development is that the approach does not, by itself, distinguish between the endogenous features of economic development. In regressing GDP per capita on the distance from equator, the empirical estimates usually result in a modestly negative correlation between the two variables. However, the distance from the equator cannot itself explain the nature of economic development and its significance over time mainly because of its low predictive power in explaining the evolution of institutions and governance.

An interesting approach has been incorporated by Acemoglu, Johnson and Robinson (2001). They incorporate a historical and institutional perspective in the empirical framework of the explanation of economic development. The authors used mortality rates of colonial settlers to explain the institutional quality. They further argue that where settlers encountered few health hazards compared to European settlement, they established solid institutions, strong enforcement of property rights and a robust system of law. In other areas where health hazards frequently occured, colonizers focused on the extraction of natural resources and showed little or no interest in building high-quality institutions. Rodrik, Subramanian and Trebbi (2002) further estimated the impact of geographic variables, institutions and openness on macroeconomic variables.

The main findings in their study were the following. First, each degree distance towards equator, on average, reduces the income per capita by 0.94 percent. The geographical location by the equator is also negatively related to capital per worker (-1.68), human capital per worker (-0.25) and total factor productivity (-0.32). Second, the quality of institutions is a very good measure of the economic welfare. In their panel, the authors found that each additional improvement in the rule of law, on average, leads to 2.22 percent increase in income per capita. The result is statistically significant at 1 percent. The improvement of institutional quality is both positively related and statistically significant when capital per worker, human capital per worker and total factor productivity are regressed on the institutional quality.

Back in 1997, Peterson Institute published an extensive study, searching the causes of corruption (link). The author estimated that the highest cost of corruption in regressing a series of macroeconomic variables on corruption index is lower education expenditure and a decrease in private investment. The estimate of the total macroeconomic cost of corruption is a difficult and daunting empirical task.

The main causes of corruption are mostly endogenous and related to the institutional evolution ranging from legal origins, colonial historical variables to the public sector efficiency variables. In search of the grain of truth, it should be noted that capturing the stylized effect of corruption of economic growth and development requires an interactive empirical approach. In other words, it would be impossible to establish "cause-and-effect" connection between corruption and development indicators without extracting a large amount of historical data and regressing it on the key endogenous variables.

Clearly, the role of geographical characteristics should not be neglected. However, the primacy of institutions in explaining the contemporary patterns of economic development is rather undisputable. Daron Acemoglu recently wrote an in-depth article on the distribution and explanatory factors regarding world poverty (link) where it clearly stressed the lack of institutions of human capital in the evolution of world poverty. When discovering the true causes of corruption, there should nonetheless be a clear and distinct rationale underlined by the evolution of institutional quality over time as the most significant measure in explaining the evolution, causes and effects of corruption on economic development.

NY Times recently reported on the agreed financial rescue assitance to Grecce from EMU (€110 billion) and IMF ($145 billion). Alongside Ireland and Mediterranean countries, the economic recovery of EMU is hampered by a high mountain of public debt and unfavorable macroeconomic data on growth, employment and current account.

Public debt in the European Union in 2009

Source: Eurostat (2009)

The graph I attached, shows the level of public debt in EU countries in 2009. Solid horizontal blue line shows the 60 percent debt-to-GDP ratio required by Maastricht criteria for each EMU entrant.

The underlying data (link) on economic recovery in the US point out a strong and robust recovery. The data from Bureau of Economic Analysis show that the US economy grew by 3.2 percent in Q1:2010 continued from a remarkable 4.6 percent growth in Q4:2009. While private consumption expenditure growth increased by 2 percentage points from the previous quarter, private domestic investment rebounded by 14.8 percent in Q1:2010 after a remarkable 46.1 percent increase in Q4:2009. In addition, labor productivity in Q4:2009 increased by 6.9 percent - the largest quarterly increase since Q3:2003 (link) On the other side, recent revision (link) of quarterly growth rate in the EMU has shown that quarterly GDP in Q1:2010 increased by 0.0 percent, revised from 0.1 percent. Industrial confidence, an important measure of manufacturing outlook, further decline by 12.2 index points.

The macroeconomic outlook for the EMU is downsized by high public debt and negative budget deficit which led 10-year bond premium spread between EMU economies and Germany (link). The premium spread between Greece and Germany stood at 8.57 percentage points on April 28 while the spread between Ireland and Germany was at 2.54 percentage points.

High level of fiscal deficits restrains the economic recovery of the EMU countries. In 2009, Spain, Ireland and Greece faced the highest deficit-to-GDP ratio while Denmark's 2 percent deficit-to-GDP ratio was the lowest in the European Union. NY Times recently collected annual dataset on public debt and budget deficit (link) in which an overview of key public finance indicators is availible.

The prospects of economic recovery in the EMU are further downgraded by unfavorable growth forecast. One of the key questions during the ongoing debt crisis has been whether the EMU will sustain fiscal discrepancy within the EMU since asymmetric fiscal policy undermine the ability of the common monetary policy. Even though Greece's debt crisis is the core of the debate regarding future viability of the single currency, growth estimates for Spain and Italy in 2010/2011 will determine the mid-term macroeconomic stability of the eurozone. European Commission recently updated the quarterly economic growth estimates for eurozone countries (link). Depending on the absorption of financial market spillovers into investment and net exports, economic growth estimates for Italy and Spain are quite pessimistic. After an estimated 0.1 percent growth rate in Q2, Spain's economy is likely to contract in Q3 by -0.2 percent and experience a slight rebound in Q4:2010. Quarterly economic forecast for Italy is positive throughout the year although the economic growth rate is likely to be close to zero. However, Italy's economic growth rate is likely to keep the increasing pace towards the end of the year although current macroeconomic outlook deters consumption, investment and inventories' contribution to GDP growth mainly because of high unemployment rate and sluggish productivity growth.

Robust economic growth is essential to the cure of high public debt. Since EMU countries have adopted a single currency, policymakers cannot trigger exchange-rate adjustment through currency depreciation. The latter would spill into higher inflation and modestly reduce the volume of public debt. Due to high unemployment and slower recovery of inventories, inflation rate is unlikely to rebound to pre-crisis levels.

EMU's most problematic countries' recovery is unlikely to be robust given public debt and deficit constraint on quarterly growth outlook. Without a prudent fiscal tightening, lower government spending, there will be a bleak economic outlook for the future of EMU countries which could result in a decade-long period of low growth, high unemployment and Japan-styled deflationary persistence.